24 June 2008

The Gold Value Chain Part II - Refining

Refiners exist because the gold that comes out of the mining process varies in purity and size but trading is more efficient if the units of trading (i.e. gold bars) are standardised. Their basic job is to convert dore (the stuff from mines) into a tradable form. Organised markets (e.g. COMEX) or trading associations (e.g. LBMA www.lbma.org.uk) set standards and rules for acceptable forms for gold and accredit refiners or their products so that market participants know exactly what they will get (or have to deliver) when they deal with each other. Very sensible.

What is that tradable form? The LBMA standard for gold is 400oz+/- @ 99.5%+ purity. Two interesting features here: first the weight is not exact and second the purity is not exact or 99.99% (the purity retail investors usually get with coins and small bars). Why? Because it is cheaper this way. We are dealing with wholesale markets here, so they don’t want to pay unnecessarily for higher purity or exact weight, especially if the physical bars will be alloyed down to 9ct, 14ct or 18ct for jewellery anyway.

With weight, it is cheaper to just pour molten gold into a mould and as long as you fill it up to the correct height, you can get a bar within +/-10% of your target weight. To get to exact weight, you need to precisely weigh out small gold granules then melt them and put into a mould (or vice versa). This process can be mechanised/automated, but there is still an additional cost involved.

With purity, 99.5% purity gold can be produced using a chlorination process (impure gold is melted and gaseous chlorine is blown through it with the impurities joining with the chlorine). It is rapid and simple and therefore cheap but only goes up to 99.5%. To get to 99.99% you need an electrolytic process (stick impure gold into a solution of hydrochloric acid and gold chloride, pass an electric current through it, the gold dissolves and pure gold moves to a negatively charged electrode). Problem is that this process costs more, mainly due to the need to keep an inventory of gold chloride on hand. It is also slower than chlorination, so you tie up gold in the process for longer.

Whether a miner has pre sold their gold or wants to sell it for spot (current cash) price, do to so they need to deliver it in a tradable form. The mining process gets gold up to a reasonable purity, but it is more efficient to give this to a refiner to get it to the acceptable 99.5% purity than for the miner to do it themselves. It is also easier for the gold industry as a whole to accredit the production processes of a few refineries than those of many miners.

So your miner (or prospector, or someone with scrap) goes to their local refinery and negotiates a refining contract. If they don’t have much bargaining power or history with the refinery, the refinery will say “look, I don’t know what the purity is of this stuff you’ve given me, so I’ll pop it through my processes and in a couple of weeks I’ll tell you how much pure gold there was in it." It is worth noting that in this example, the refinery doesn’t actually own the gold, the miner still has title to it and the refinery is just processing it for them – sometimes known as toll refining. The refinery charges a fee for this service and theoretically at the end the miner could ask for a bar of 99.5% gold. In practice, few actually do this. Why?

Firstly, the amount of gold delivered for refining rarely equals an exact quantity of 400oz bars. If it is a prospector, then the amount may not even be 400oz. So for small lots you would end up with a bar that, while of a tradable purity, is not in a tradable size. Secondly, miners (and a fair number of prospectors) are really after cash and not physical bars. They don’t want the hassle of taking delivery from the refinery, finding a buyer and arranging shipment.

So their friendly refinery offers to do all this work for them, and therefore most usually sell their refined gold directly the refinery itself and leave them with the work of finding a buyer and shipment. This process of buying from its customers and on-selling to someone else is simple enough but it gets a bit more complex when a miner wants to settle its hedging contracts.

Loco Swaps

Miners can hedge either via COMEX futures or a deal with a bullion bank. In either case, for the miner to settle its contracts it needs deliver refined gold to a COMEX warehouse or to the account of a bullion bank in London. From the point of view of the industry as whole, however, this is not always efficient.

For example, with a huge demand in India for 99.99% kilo bars it would not make much sense for an Australian miner to ship 99.5% 400oz bars to London, then the bullion bank to ship it to a refinery, which reprocesses into 99.99% kilo bars and then ships it again to India for eventual sale. Australia’s refinery, AGR Matthey, would rather keep the gold, immediately further process the gold into 99.99% purity and directly ship to India. This is cheaper, keeps the price down which means Indians can buy more gold, which we would all agree is A Very Good Thing.

But the miner needs gold in London. So, continuing with our example, AGR Matthey offers to do a loco swap (short for location swap). In effect, the deal is “you give me title to your refined gold in Australia and I will give you title to gold in London.” The miner and refinery are swapping gold in different locations. This begs the question “why has the refinery got gold in London” and the answer is “it doesn’t have any”. Whaaat, you say? This is where our goods friends the bullion banks and their buddies the central banks come in.

As noted in previous blogs, the central banks are sitting on lots of gold which isn’t earning them anything so they ask bullion banks to try and earn a return on it for them. So AGR Matthey rings up a bullion bank and asks if it can lease 400oz gold for a month. "No problem", says the bullion bank, "I’ve got heaps sitting around to lend to you". AGR Matthey now has 400oz physical gold in London (asset) but also a 400oz lease to repay in a month (liability).

Just a side note here: AGR Matthey’s ounce assets and ounce liabilities match equally, so it is not exposed to any movement in the price. For example, if the price drops from $1000 to $800, the value of its physical gold goes down to $320,000 but the liability also drops to $320,000. Its (ounce) balance sheet always equals zero.

With gold in London, AGR Matthey can now do the swap with the miner. It transfers the London gold from its account to the miner’s account and takes control of the physical gold in Australia. The miner can then use the London gold to meet its contractual obligations, or if it is unhedged, simply sell it. From AGR Matthey’s point of view, it still has a liability (in London) for 400oz, but instead now has 400oz of physical gold in Australia rather than London.

Sale of Gold

The process of refining up to 99.99% and then finding buyers in India and shipping it to them takes time, hence that’s why AGR Matthey asked for a one month lease. During this time it owns the physical gold, offset by the lease liability. It ships it to India and when it has found a buyer, it sells the physical gold to them and using the cash from the sale, immediately buys 400oz of gold in London. It has lost title to physical gold in India but gained title to gold in London. It can now use this London gold to repay the lease to the bullion bank, who can return it to the central bank, plus the lease fee.

This process is similar in a way to what I described with miners and hedging. Once the loco swap has been performed, ultimately the lease from the central bank is “secured” or “backed” by the physical gold held in the refinery. There is no short selling involved. The central bank, by providing gold for lease, has actually facilitated the manufacturing and selling process of physical gold, enabling it to be done efficiently and therefore cheaper. As I’ve said before, leasing itself is not bad; it is who gold is leased to and what they do with the gold that matters.

Next week we’ll go into more detail about gold manufacturing and trading. Leasing will feature again and we’ll introduce loco discounts and metal accounts.

1 comment:

Excellent stuff.. Really learning from your blog...Can you please write a post explaining costs of refining. How much does a refinery charge a mining company to refine its gold to lbma standard? And all the permutations on pricing... Payment in advance vs a piece of the action etc...

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